Modeling the Global Effects of the COVID-19 Sudden Stop in Capital Flows

Abstract: The COVID-19 outbreak has triggered unusually fast outﬂows of dollar funding from emerging market economies (EMEs). These outflows are known as “sudden stop” episodes, and they are typically followed by economic contractions. In this post, we assess the macroeconomic eﬀects of the COVID-induced sudden stop of capital flows to EMEs, using our open-economy DSGE model. Unlike existing frameworks, such as the Federal Reserve Board’s SIGMA model, our model features both domestic and international ﬁnancial constraints, making it well-suited to capture the eﬀects of an outﬂow of dollar funding. The model predicts output losses in EMEs due in part to the adverse eﬀect of local currency depreciation on private-sector balance sheets with dollar debts. The ﬁnancial stresses in EMEs, in turn, spill back to the U.S. economy, through both trade and ﬁnancial channels. The model-predicted output losses are persistent (consistent with previous sudden stop episodes), with financial effects being a significant drag on the recovery. We stress that we are only tracing out the effects of one particular channel (the stop of capital flows and its associated effect on funding costs) and not the totality of COVID-related effects.